Inching toward NGDP targeting

An increasing number of important people recognize that NGDP level targeting is superior to inflation targeting. Nonetheless, the Fed is unlikely to suddenly switch to NGDP targeting. Rather, the change will occur gradually over time, in stages.

Let’s think about a policy of price level targeting. In what situations would that move us closer to NGDP level targeting, and when would it be inappropriate?

1. Suppose a supply shock suddenly hits the economy, such as a surge in imported oil prices caused by a shutoff of oil from an important exporter. This shock might push inflation higher and output lower. The effect on NGDP would be small.

If the Fed were targeting the price level, and the oil shock pushed inflation up to 4%, then they would be required to aim for 0% inflation next year, or 1% inflation over the next two years.

But if the oil shock has little or no impact on NGDP, that reversion to the price level trend line would actually be inappropriate. So price level targeting does not do well when there is a supply shock to the economy.

2. Suppose a demand shock suddenly pushes inflation much higher or much lower. In that case, NGDP will also rise or fall relative to trend, indeed by even more than inflation. Now a reversion back to the trend line would be appropriate. If the economy temporarily overheats, then profits will initially rise sharply. Wages are sticky and don’t move much in the short run. Bringing prices down will help to push profits back down to a more normal level, and insure macroeconomic stability.

An even more important example occurs when there is a sudden fall in inflation due to a negative demand shock. In this case, it helps to run inflation at levels above normal in a catch-up period, as this will also help to restore NGDP to its trend line and shorten the recession. A negative demand shock is perhaps the clearest case where price level targeting helps to stabilize the economy by mimicking the effects of NGDP level targeting.

When Ben Bernanke recently proposed a modified form of price level targeting, he suggested that whenever the economy falls to the zero bound during a recession, the Fed should commit to price level targeting until the previous trend line is restored. Note that recessions that push interest rates to zero are almost always caused by negative demand shocks.

Why is this important? Because Bernanke’s proposal is the single most likely outcome of the Fed’s June conference to re-evaluate its policy strategy. It is also the form of price level targeting that most closely approximates the best aspects of NGDP targeting. It is a policy that implicitly says we should not always do price level targeting, rather do it when it would be most likely to produce NGDP level targeting-like results.

The market part of market monetarism will also happen in stages. The Fed is already paying more and more attention to market indicators and less to Phillips Curve-based models of inflation (which haven’t worked.) Next step is to change the fed funds target daily, in increments of 1/100%, with up and down moves equally likely. That’s how markets behave. An NGDP futures market guardrail is still a few decades away.

In their heart, Fed officials must know by now that NGDP targeting would have been better than inflation targeting. But we will get there in baby steps, which is probably how it should be. Monetary policy is too important to make a sudden lurch into the unknown.